Commentaries

The VaR cover-up

By Pablo Triana

Pablo Triana is the author of Lecturing Birds On Flying: Can Mathematical Theories Destroy The Financial Markets? The views expressed are his own

Last month, several men and women assembled in a somber room in Washington to discuss one of the key issues (in my opinion, the key issue) behind the financial crisis that has caused so much misery.

Among those gathered were leading politicians and top financial professionals. A world-renowned bestselling author was there, too. You might think that the media would have devoted attention to such an important event. Surely journalists wouldn’t want to miss the opportunity to report on a roundtable of policymakers and experts that promised to tackle the true factors behind the mayhem, right?

Wrong. (more…)

Automatic debt-to-equity swap?

That’s what Fed Governor Daniel Tarullo seems to be advocating in his speech, which you can find here.

Here’s the graph, emphasis mine:

We must also adopt new regulatory mechanisms to counteract the systemic and too-big-to-fail problems that became so embedded in our financial system. One possible approach is a special charge–possibly a special capital requirement–that would be calibrated to the systemic importance of a firm. Needless to say, developing a metric for such a requirement is a new, and not altogether straightforward, exercise. Another proposal, which strikes me as having particular promise, is that large financial institutions be required to have specified forms of “contingent capital.” One form of this proposal would have firms regularly issue special debt instruments that would convert to equity during times of financial stress. If well devised, such instruments would not only provide an increased capital buffer at the moment when it is most needed. They would also inject an additional element of market discipline into large financial firms, since the price of those instruments would reflect market perceptions of the stability of the firm.

Yeah, who cares about the bondholder as long as the bank is OK. These are likely to be a tough sell and the banks most likely would have to pay, as they should, a hefty premium to get investors to agree to such a provision.

Volker cuts through it

Paul Volcker, the former Fed chairman whose nerves of steel broke the back of double-digit inflation 30 years ago, shows that he’s still one of the few in government that wants to call the tough shots.  Too bad he isn’t more influential. If he were, I doubt Wall Street would be talking about getting back to business as usual.

From the WSJ:

Mr. Volcker, who currently is chairman of the White House’s Economic Recovery Advisory Board, suggested banks should be restricted to trading on their client’s behalf instead of making bets with their own money through internal units that often act like hedge funds.

“Extensive participation in the impersonal, transaction-oriented capital market does not seem to me an intrinsic part of commercial banking,” he said in a speech to the Association for Corporate Growth in Los Angeles.

The article goes on to say that Volcker will speak before Congress to talk more about his proposals, but don’t imagine it will gain much traction.

Why banks should welcome “living wills”

A year after Lehman Brothers collapsed, policymakers are still getting to grips with the key question raised by the Wall Street firm’s fall: how to ensure that the failure of a large bank does not jeopardise the entire financial system.

After much debate, politicians and central bankers are warming to the idea that banks should make preparations for their own failure. This plan — memorably dubbed a “living will” by Mervyn King, governor of the Bank of England — would allow regulators to wind down even large, cross-border institutions without putting public money at risk.

Alistair Darling, Britain’s chancellor, wants to introduce legislation this autumn to force banks to draw up living wills. Such plans have drawn predictable squeals from bank executives, who claim the idea is hard to implement for large cross-border groups. They have a point. Nevertheless, bankers should embrace the idea, for the simple reason that it is better than any of the alternatives.

The status quo is no longer acceptable, so policymakers have three choices for dealing with large, systemically important financial institutions. The first is to make them smaller so that the collapse of any one bank would no longer threaten the system. The second option is to take a “zero failure” approach to regulation, along the lines of safety rules in the airline industry.

Both of these approaches have flaws. Small banks still pose a risk if they all collapse together. And preventing failures entirely would require a level of regulation that would stifle innovation and further reduce competition in financial services.

By contrast, a system of living wills would be far less intrusive. This is not to suggest the switch would be straightforward. Differences in national insolvency laws mean it is currently impossible to establish a consistent approach to winding up complex cross-border institutions. Politicians’ desire to protect local depositors and taxpayers — often at the expense of foreigners — also complicates matters. Simplifying corporate structures that have evolved over decades will also not be easy.

And even assuming that all these problems can be overcome, governments would still struggle to convince investors that they were really willing to use their powers.

Cleaning up the mess that remains

At least the Obama administration isn’t saying “Mission Accomplished.”

In marking the anniversary of Lehman Brothers’ demise, the administration understandably focused on how far we’ve come since, and on the various exit strategies in the works.

Lehman Brothers has been at the center of the narrative of what went wrong last year, and that makes it much easier for the administration to tell a story of triumph rather than the more uncomfortable legacy of dysfunctional companies and hidden toxic assets.

Coinciding with President Barack Obama’s speech in New York, the Treasury released a paper today, titled “The Next Phase of Government Financial Stabilization and Rehabilitation Policies.”

Its summary reads like a check list of emergency programs that are no longer needed now that the worst of the crisis is past. The insurance program for money market funds and the federal guarantee of qualifying bank debt can be tied directly to the fallout from Lehman’s spectacular end.

But last year’s turmoil didn’t begin and end with Lehman. Change the anniversary’s focus to, say, the government’s seizure of Fannie Mae and Freddie Mac that occurred a week earlier, or to American International Group, just a day after, and it’s clear that some of the messier legacies of the credit crisis still haunt the current administration a year later.

The government arguably isn’t any closer to figuring out what to do with the two giant housing finance companies than the previous administration was on September 7, 2008, when it announced Fannie and Freddie would be put into conservatorship.

Obama urging Wall Street to do the right thing

In his speech, Obama emphasizes that big banks should take it upon themselves to give back to the community after the tax payer has done so much to put them on them on the road to recovery. While I agree with the point in theory, I’m not sure Wall Street is built to think about the moral imperative of creating a better society when it’s primary goal is to make money.

Wall Street, and I use this term broadly, has already demonstrated that when it’s presented with a  choice, it chooses the money. While many bristle at the thought of more regulation, especially when it means it could undermine financial innovation – God forbid – one of the important take aways from the crisis should be there needs to be a counterweight to greed. The industry cannot regulate itself.

From the speech, which you can see in all its glory on Felix’s blog.

The fact is, many of the firms that are now returning to prosperity owe a debt to the American people. Though they were not the cause of the crisis, American taxpayers through their government took extraordinary action to stabilize the financial industry. They shouldered the burden of the bailout and they are still bearing the burden of the fallout – in lost jobs, lost homes and lost opportunities. It is neither right nor responsible after you’ve recovered with the help of your government to shirk your obligation to the goal of wider recovery, a more stable system, and a more broadly shared prosperity.

So I want to urge you to demonstrate that you take this obligation to heart. To put greater effort into helping families who need their mortgages modified under my administration’s homeownership plan. To help small business owners who desperately need loans and who are bearing the brunt of the decline in available credit. To help communities that would benefit from the financing you could provide, or the community development institutions you could support. To come up with creative approaches to improve financial education and to bring banking to those who live and work entirely outside the banking system. And, of course, to embrace serious financial reform, not fight it.

Squeeze is on for investment banks

Investment banks are facing a big squeeze. For an industry that was generating record revenues just months after the collapse of Lehman Brothers, this may seem unlikely. But the revival looks set to be short-lived. Increased regulation and greater competition means the super-charged returns the industry generated for most of the past decade are likely to prove elusive.

Analysts at JPMorgan believe 2009 will prove to be the high point in the investment banks’ relentless upward march. They expect revenues in 2011 to be no higher than in 2006. More significantly, the industry’s return on equity will fall to 10.8 percent, far lower than what they have got used to.

What explains this reversal? Regulation plays a big part. Contrary to the received wisdom that investment bankers are being allowed to carry on much as before the crisis, regulators have whacked up capital requirements for complex, illiquid products. These were the source of much of investment banks’ profit during the boom, and most of the trouble since. Higher capital charges will make a lot of what banks’ structured credit desks used to do unviable, and reduce the profitability of what remains. Caps on leverage will also make it harder for banks to juice returns.

Similarly, the drive to ensure more derivatives are traded on an exchange or, at the very least, cleared through a central counterparty will have a big impact. Blowing away the fog that surrounds derivatives will make it harder for banks to hide their true cost from clients and clear the way for new players to enter the market.

Indeed, competition is on the rise across the board. Investment banks enjoyed near-perfect conditions in the first half of the year, as volatile markets boosted trading activity while those that had survived the crunch were able to demand wider spreads. But many of the banks that got into trouble are now rushing back into the market, helped by cheap state-subsidised funding.

Of course, banks will not sit still. Anyone who witnessed the wholesale shift from equities into fixed income following the stock market crash of 2001-2002 will recognise that the industry has an extraordinary knack for rapid self-reinvention. Most houses are already cleaning up with fat fees as companies issue equity to pay off some of the debt they took on during the credit boom. Banks also have a long track record of circumventing new regulation.

Nevertheless, it’s hard to see any new business permanently filling the hole left by the structured credit collapse. Regulators will also be much more vigilant with banks seeking to pile risky assets — of any description — onto their balance sheets. This means the majority of future business is going to have to come from more old-fashioned activities such as underwriting, advising and trading — all of which are less profitable.

Orange squeezes the UK’s mobile competition

Merging T-Mobile UK with Orange will bring 3.5 billion pounds of value to shareholders, and “substantial benefits to UK customers.” Goodness, why on earth didn’t they get together years ago? A merger that simultaneously enriches shareholders and customers is rare indeed, and one to be treasured – if this really is one of those seldom-seen beasts.

While the 3.5 billion pound figure is credible, the second claim, from Timotheus Hottges, the finance director of Deutsche Telecom, T-Mobile’s parent, is harder to believe. The immediate reaction from other shares in the sector rather gave the game away, with retailer Carphone Warehouse down on the prospect of fewer suppliers, and Vodafone up on the hope of less competition in Britain’s mobile phone market.

Mixing Orange with T-Mobile’s garish purple would create a business with 37 percent of that market, rising to 42 percent if Virgin Media, which piggy-backs on T-Mobile, is included. Britain’s Competition Commission, fresh from being bludgeoned into accepting a bank merger which breaks all the rules, will be itching for a look. It’s only one thicket in the regulatory maze which Deutsche and France Telecom, the owner of Orange, will have to negotiate. The deal will go to the European Commission, and Britain’s Office of Fair Trading can ask for it back (to send it to the CC) while Ofcom, Britain’s telecoms regulator,  is also on the line.

It’s not immediately obvious why this deal should be allowed. There are currently four substantial UK mobile operators, with the awkwardly-named 3 a distant fifth. It hasn’t a hope of making money, but it has dictated lower prices to the others. The worry for UK consumers is that if T-Orange is allowed, 3 will fold, and that five would become three.

Aside from the standard boiler-plate about investing more to make Britain a more communicative place, the new venture can offer one significant sop to the regulators. The sale of the next slice of radio spectrum is overdue, and an undertaking not to ask for more would allow the other two to promise more investment in “digital Britain” in return for a lower purchase price.

If the regulators can somehow be persuaded, the future’s bright. The merger is presented as a genuine 50-50 affair, but Orange is the stronger brand, thanks to the legacy of its inspired marketing a decade ago. A joint venture also spares Deutsche from being forced to recognise T-Mobile’s market value on its books; from initial hopes of a 4 billion pound sale, it’s become clear that neither Vodafone nor O2, Telefonica’s British arm, was prepared to pay more than a fire sale price.

As they sketched out their route to the broad sunlit uplands, the new partners were keen on Tuesday to emphasise improved network coverage, better use of the combined spectrum, and the lovely savings from closing overlapping shops, marketing and radio sites. It all sounds wonderful, but the history of joint ventures is not a happy one. Besides, it’s one thing for consumers to pay up voluntarily for the delights of evolving technology and quite another to be forced to pay more because competition is cut.

Wall Street’s $4 trillion kitty

The Obama administration’s plan for reining in derivatives leaves unchecked one of Wall Street’s dirty little secrets: the ability of a derivatives dealer to redeploy cash collateral that gets posted by one of its trading partners.

On Wall Street, this practice of taking collateral and reusing it is called rehypothecation. In essence, it’s a form of free money for derivatives dealers to use as they please — even to repost it as collateral to finance their parent company’s own borrowings.

And we’re talking big bucks. The International Swaps and Derivatives Association recently reported that derivatives dealers have taken in $4 trillion in collateral from their trading partners. That’s an 86 percent increase over the $2.1 trillion in cash collateral those same dealers reported having on their books in early 2008.

Now it’s not surprising that investment firms took in more collateral from their trading partners over the last year, when the financial markets were in turmoil. Cash collateral is one way for derivatives dealers to protect themselves against the risk of a trading partner defaulting on one of these sophisticated financial contracts.

There’s nothing wrong with a dealer taking legitimate steps to insure an orderly unwind of a busted trade.

But Wall Street firms should not have free license to reuse this collateral any way they see fit. The Obama administration should revise its proposal to require derivatives dealers to hold all cash collateral in segregated escrow accounts that can’t be reused or touched by the dealer.

The same rule should also apply with any collateral that is posted with a regulated exchange on which a derivative contract gets traded.

Team Obama punts again on derivatives

The Obama administration formally sent its plan for regulating derivatives to Capitol Hill today. And to no one’s surprise, the key proposal in the 115-bill is a plan to regulate “standard” derivatives on regulated exchanges of clearinghouses.

As I’ve pointed out a number of times, Team Obama has yet to come-up with a workable definition for a standard derivative. The administration seems content to kick the issue down the road.

The bill would leave it up to the discretion of the CFTC and SEC to develop a definition of a standard derivative. The agencies have up to 180 days after the law is enacted to formulate a definition.

Team Obama says the definition should be as broad as possible and says regulators should consider things like trading volume in specific transactions and whether agreements have similar terminology. Also, in a bit of circular sounding reasoning, the bill says:

A swap that is accepted for clearing by any registered derivatives clearing organization shall be presumed to be standardized.

But I’d like to have seen more leadership on this issue from the White House. Leaving it to the regulators to decide will allow an opportunity for the industry to get their hooks into this and potentially create a mess. It would have been better if Treasury took an initial stab at this by promulgating its own definition of a standard derivative.

I fear this will permit too many derivatives to be classified as non-standard contracts–something that would exempt them from being traded on an exchange.